Tuesday, January 18, 2011

From Continentals to Federal Reserve Notes

In the previous post, I called attention to the alarming rate at which the Federal government is "creating" dollars. But what does that mean? Exactly how does the government create new dollars?

The mechanics of the current system are well-documented, and are not an arcane secret. But we first have to distinguish carefully between actual paper dollars which you put in your wallet, and the intangible, electronic dollars in bank accounts.

The paper dollars with which we are all familiar are printed by the United States Bureau of Engraving and Printing -- separate from the United States Mint, which (until the Civil War) produced only gold and silver coins. The Constitution gives Congress the power to "coin" money. In 1789, its drafters had vividly in mind the poor reputation of the paper "Continentals" printed to finance the Revolutionary War when England had forbidden the Colonies to create their own money, and tried to cut off the supply of pounds sterling. Congress responded by printing the paper currency, and printed too much at once, with the result that it immediately depreciated. This damage to its image was exacerbated by the British, who (according to Benjamin Franklin) skillfully counterfeited the bills in huge quantities in New York, in an attempt to bring down the Revolution. That attempt failed, and the Continentals, even though greatly depreciated, were essential to the new republic's survival, and eventual victory in the War. The aftermath of the counterfeiting took its real toll after the War was over in 1783, and individuals tried to profit from the huge quantities of look-alike currency that Britain had introduced into the New England colonial economy.

From the founding of the United States in 1789, until the Civil War made huge new expenditures necessary, the government's mint produced only hard coinage, in denominations of silver and gold. (Attempts to operate a national bank under the aegis of the federal government, authorized to issue its own paper notes, came to an end when President Andrew Jackson refused to renew its charter. There were other private banks which also issued their own paper notes, but when those banks failed, their notes became worthless.)

Salmon P. Chase, who as Secretary of the Treasury under President Abraham Lincoln, had overseen the issuance and distribution of paper "demand notes" to finance the Union's cause (called "greenbacks" because of the color printed on their reverse side, and bearing his picture on the obverse!), joined (after Lincoln had elevated him to the Supreme Court) a majority which initially ruled that the authorization of the greenbacks had been unconstitutional (!). That 4-3 decision was itself overturned just a year later in the Legal Tender Cases, by a vote of 5-4, after President Grant had appointed two more justices to the Court, pursuant to an act of Congress which had increased the number of justices from seven to nine. In that manner, the verb "to coin" as used in the Constitution was held to subsume, when it came to money, the verb "to print."

Eventually, nearly all the greenbacks ($250 million worth) issued to finance the Union during the Civil War were exchanged for gold or silver coin, and so (contrary again to the popular understanding), our first national venture into paper money did not turn out badly. (Any greenbacks which remain outstanding are still valid legal tender today, though they are worth far more unredeemed.) Paper money on a national scale was not introduced again until after Congress had created the Federal Reserve Bank in 1913.

Paper succeeded as money for only two reasons at first: (1) it was much more convenient to carry, say, a $10,000 paper bill than the equivalent amount in gold coins; and (2) every paper bill contained a legend that made it fully exchangeable on demand, at any branch of the Federal Reserve, for its equivalent in gold or silver. When I was growing up, the paper money I used bore the legend "Silver Certificate", and specified that it was exchangeable for an equivalent amount of silver coin, "payable . . . to the bearer on demand":

Over time, the convenience of paper money gradually overcame the need for its exchangeability. The latter was assumed, but rarely put to the test in practice. The function of the paper currency, however, did not change. By virtue of its original exchangeability for a form of hard currency, paper currency came to be seen as the equivalent of the real thing -- silver and gold.

The function of a paper dollar, however, was subtly different from the function of a silver dollar. The latter could be exchanged, but primarily for goods and services; a paper dollar could also be so exchanged, but its value in being so capable of exchange derived from the fact that any person holding it could at any time, with no questions asked, obtain its equivalent in actual silver coin.

It is at this point that we come to a fundamental distinction about money, which must be drawn if we are to understand the faults of the current system. This distinction may be expressed as the difference between value and wealth.

Properly speaking, wealth is everyone's goal: to acquire sufficient assets to have no worry for future needs or concerns. Superficially, and commonly, we are used to measuring wealth in units of money. That is only a convention, however, which allows all of the complicated mix of a typical person's collection of assets to be valued in terms of a single unit of value, the dollar. The assets are each converted to dollar values (through appraisals, or index look-ups, or whatever means is appropriate), and the total of the individual values represents the measure of that individual's wealth, expressed in dollars.

Wealth, properly understood, does not consist of dollars. Dollars are the measure of one's wealth. And the measure the dollar makes at any one point in time depends on the dollar's relative value with respect to other commodities, currencies, and exchangeable assets. If government inflates the supply of dollars in a given economy, prices will go up, because there are more dollars seeking to be exchanged for real goods and services. Someone who holds only dollars as assets will be made poorer by inflation: his dollars will buy less and less at the store. So that is why dollars can never be regarded as wealth. And the distinction is crucial if we are to understand what our current "money" is, and what function it serves.

Strictly speaking, money is a means of exchange. If you are starving on a desert island, with a trunk full of pirates' gold, you may have lots of money, but it is worthless to you in that situation. You cannot eat it, or use it to stay alive in any fashion. Its value comes solely from your ability to exchange it for something else which you value more, namely, food and water. As we all know, the value of the latter can increase greatly in times of famine and shortage, and require us to exchange much more in money to obtain them than we might in more normal circumstances. Money -- in whatever form -- is therefore useful only insofar as it will (a) retain enough value so that we can exchange it for what we need in any given situation; and (b) -- what comes to the same thing -- resist or hinder any attempt to depreciate it.

Money has taken all kinds of forms over time, depending on the environment in which it is used. People have used shells, rocks, beads, and all kinds of other objects which had the properties of being (a) relatively scarce to begin with, and (b) difficult to acquire or augment. In a sort of Darwinian survival of the fittest, the development of money has been an evolutionary process, with the most convenient and durable forms winning out over all the others.

The process continues apace, so that what was convenient twenty or thirty years ago is continually being replaced by something that serves the purposes of money better today. And this continued evolution has tended, in our society, first to favor paper dollars over gold and silver ones, and more recently, electronic and digital dollars over paper ones.

But another development has occurred at the same time, which (if known beforehand) could never have been rationally intended. On the model of the old "silver certificates", the government has seen fit to retain paper currencies as "promises to pay." Beginning in 1964, however, we no longer could demand performance of that promise by delivery of an amount of silver equivalent to the total paper bills surrendered. Silver certificates were taken out of circulation in 1964, and the "new money", in the form of "Federal Reserve notes", was introduced in its place:

These new forms of paper currency were no longer "certificates", but "notes." And a note is a promise to pay. But -- pay what? When I look at the picture of the Federal Reserve note just reproduced, what is it a note for? What will I get if I "collect" on the note?

As I said, you will no longer get an equivalent amount of silver. Your Federal Reserve note is officially exchangeable only for another one of like kind. A note is replaced with another note -- and so it remains perpetually a promise to pay. When you pay for some goods in cash, you pass those promises to pay on to the seller of the goods, who accepts them so that he or she may pass them on to another in turn. Welcome to the world of fiat currency, where currency ("legal tender for all debts, public and private", as is printed on each note) is whatever the Government by law says it is -- in this case, Federal Reserve notes.

Notice that fiat currency divorces the value of money from its medium. Gold and silver coins maintained their value, because they could always be melted and sold as the metal itself. There is no inherent value to speak of, however, in the paper on which our currency is printed. We ascribe whatever value paper money has to what it can buy us in goods and services, and not to the medium in which it is embodied.

In this post, we have contrasted the difference between coined money and paper money, or fiat currency. In the next post, we will look at the difference between paper money and electronic money. Then we will finally be in a position to understand just what money is. And that knowledge will help us see what is so wrong with our current monetary system.


  1. Mr. Haley,

    I think it might be useful information for readers who are not wholly familiar with the term to have an explanation of the legal implications of the concept of legal tender in law. I had used the term freely for years without such an understanding and only recently learned a more precise meaning—which was a significant personal epiphany.

    As I understand it, and I invite you to amend or correct anything below in which I am in error or deficient, debts and payments may be required by the creditor to be paid in legal tender, and may not be required to be paid in any other medium of exchange. Which is to say that a seller/lender may demand that payment may be made only in legal tender. By contrast, it can be, but is not necessarily, the case that the law may permit two contracting parties to agree to payment in other than legal tender.

    Pax et bonum,
    Keith Töpfer

  2. Being an ignoramus in these matters, perhaps you could clarify something for me.

    While I understand that gold and silver currency can be reduced to its original medium, the value of gold and silver is also not fixed but does fluctuate (though presumably less so over time than does paper currency).

    Society has to date chosen to put a greater value on precious metal than it does on paper, yet until recently it was assumed that property holding was the most desirable way of husbanding assets (given that there was always the the assumption - pre-housing bubble - of demand exceeding supply).

    Is the "value" of gold and silver, therefore, simply a function of its rarity, or is there some other reason? Given the recent concern expressed over "rare earths," do they not have the potential to become an ultimate currency?

  3. Martial Artist, "legal tender" is a term that defines the form of money in which, by law, any debt -- public or private -- may be satisfied in full. The federal government has an exclusive monopoly, granted by the Constitution, to define what "money" is, and whatever it so defines as money thereby becomes "legal tender."

    When Justice Chase voted to declare the greenbacks unconstitutional, he did not attack them directly for not being "money" in the sense that gold and silver coins were. He ruled that the government had violated the Fifth Amendment (taking private property without just compensation) by declaring that the greenbacks were legal tender. And this was a debatable point, because they could still be exchanged "on demand" for coins of the realm -- but if everyone had done so at once, of course, the Mint would have run out of coins.

    Congress ended the dual coin/paper money system in 1934, with the passage of the Gold Reserve Act. The Supreme Court upheld the validity of Congress' power to require that paper currency, as legal tender, be accepted in full payment of contracts calling for payment in gold coin, or specie. That Act, and that decision, served as the death knell for gold coins as currency. In a modern-day illustration of Gresham's Law, gold coins were hoarded and taken out of circulation, being replaced entirely by the cheaper paper currency.

  4. Jeremy Bonner, you are correct: once the dollar was no longer defined as a given quantity of gold, then the price of gold in dollars became free to fluctuate, and as we know, it has gone mostly upward ever since. As a commodity, gold can be valued in relation to what one can exchange for it (including dollars, but maybe not for much longer). That value is not so much a function of its rarity (in nature), as it is of the limited supply available for purchase at any one time. When the price of gold is high enough, gold mines are profitable, and more gold is added to the supply (but not all that much -- gold is difficult to find and to extract). The fact that the price of gold in dollars has gone steadily upward in recent years, despite a steadily increasing supply, is a direct consequence of the huge quantities of dollars in circulation. A graph of the price of gold in Swiss francs would show a more reliable picture of its change in value over time.

    The ultimate point is that the more convenient is the form which our money takes, the easier it is to multiply it, and hence depreciate its value. Gold coins were not all that convenient; paper dollars roll off the printing presses like water.

  5. I'm sure Mr. Haley is familiar with the work, but for anyone interested in learning more on the subject of how money works and the history of governmental shenanigans with it, I highly recommend Money Mischief by Milton and Rose Friedman.